The changing landscape of India’s equity markets

About three years ago, soon after a change in its leadership, the Securities and Exchange Board of India (Sebi) allowed direct market access to institutional investors and the use of algorithmic trading strategies. But because of the steep fall in equities in 2008, few clients were willing to make investments in trading technology, and it wasn’t until 2009 that things started moving.

Shyamal Banerjee/Mint

Since then, market participants have adopted to electronic trading like a duck to water. In a recent Futures Industry Association (FIA) conference in Mumbai, an official from the National Stock Exchange (NSE) said 60% of the orders coming into the exchange were from co-located servers.

NSE started co-location facilities for its members in January 2010, about 15 months ago, and the pace of adoption is fascinating. With co-location facilities, members can set up automated trading systems in the same building as the exchange. With this, the time taken for market data going out from the exchange and for order messages to come in from members (also known as latency) reduces considerably. Low latency is critical for algorithmic trading, and exchanges, brokers and traders world-wide are investing millions of dollars to enhance trading efficiency.

The fact that about 60% of orders into the country’s main exchange are coming from co-located servers shows that high-frequency trading has come onshore in a big way. At the TradeTech India 2011 conference, a conference held for users and vendors of electronic trading services, Greg Lee, head of Autobahn Equity Asia, Deutsche Bank’s electronic equity trading platform, showed in a rather neat presentation how volumes in India have exploded since the use of electronic trading caught on in 2009.

According to him, the bid-ask spreads narrowed considerably at the National Stock Exchange. And there was improvement at the Bombay Stock Exchange as well. While the reduction in spreads hasn’t been as much as on the NSE, in the second half of 2010, the number of order book quote changes on BSE doubled in number. Lee added that the speedy changes in the order book suggest that some market participants are engaging in automated market making.

While large domestic and international brokers have taken up space for co-located servers, it’s interesting to note that a number of start-up firms have also done so. According to an exchange official, some of these new firms are contributing significantly to the volumes in the markets. It’s anybody’s guess if these firms are making money.

What’s more important is that the explosion in liquidity and the sharp reduction in bid-ask spreads is a boon for the markets and benefits all market participants. Of course, high-frequency traders tend to stick to liquid stocks and liquid derivatives contracts. Hence, they haven’t yet contributed meaningfully in enhancing liquidity of the other stocks and illiquid derivatives contracts such as stock options.

Needless to say, the larger concern about high-frequency trading (HFT) is that it could destabilize markets, especially after the flash crash in the US on 6 May 2010. It must be noted that such a situation can arise even in a world without HFT. A flash crash situation arises when a large order is placed into a thin order book inadvertently.

Besides, the Indian markets are much better placed vis-à-vis the US markets, thanks to the practice of collecting margins on a real-time basis. If a member firm exhausts its margin with an exchange, it is barred from taking fresh positions.

Having said that, given the changing landscape of the Indian equity markets and the increase of high-frequency trading, it’s imperative that the markets regulator develops expertise in analyzing and acting on trading information in real-time. It would be unfortunate if this lesson is learnt only after going through a flash crash like situation in our markets.

If it ain’t broke, break it

Under its previous chairman C.B. Bhave, Sebi had some of the most fruitful years in its history. The area which improved the most was the enforcement function of the regulator. Earlier, Sebi’s orders were almost invariably challenged successfully at the Securities Appellate Tribunal (SAT). But Bhave brought in a team that not only did top-notch investigation, but also put out well-written orders, to make sure the case made against culprits was water-tight.

Sadly, this team is gradually being dismantled. According to a report in The Economic Times, the finance ministry is hunting for successors for two whole-time members whose three-year terms end in July this year. Like Bhave, these members could have been given a two-year extension, but this option seems to have been disregarded.

Needless to say, the securities markets would have benefited immensely if this proven team was allowed to continue. For one, there are some important investigations such as the Reliance Industries Ltd insider trading case that haven’t concluded. Besides, some level of continuity is important in a market that is changing rapidly.